Written by

Dr. Rumki Majumdar

Published

June 19, 2013

It is “real” this time

There has been more good news for Japan’s economy since our last outlook for the country in April: The “real” economy is responding to the prime minister’s “Abenomics.” Real economic activities have shown strong signs of growth in Q1 2013 relative to the previous quarter, while the overall economic sentiments continued to improve in April. Real GDP grew quarter over quarter by 0.9 percent, with strong private consumer spending and export gains respectively contributing 0.6 percent and 0.5 percent to the growth. The gains outweighed the weakest business investment in the wake of the March 2011 earthquake and tsunami. However, year-over-year consumer-price inflation (excluding energy) tumbled by 1 percent last quarter, the highest fall since Q3 2010, which is a setback for policy makers as they seek to end more than a decade of deflation. The financial sector, which witnessed substantial improvement in the last couple of months, probably has been seeing some short-term corrections lately.

Growth in real private consumption expenditure

Real private consumption expenditure, which accounts for 60 percent of GDP, grew at the same rate as real GDP. Two factors that have largely contributed to the strong growth in private consumption are steadily recovering consumer confidence and an improving consumer balance sheet.

According to the government survey in April, the consumer confidence index remained close to its highest level since 2008, as the outlook for livelihood, income growth, employment, and willingness to purchase improved among consumers. The other factor that contributed to the increase in consumption expenditure is the significant improvement in the household balance sheet. The household sector’s net wealth improved substantially and consistently in the last year. The steep rise in the equity index led to a strong wealth effect—a term that describes consumers’ tendency to spend more when their wealth increases. The Senior Loan Officer Opinion survey in April too shows a strong increase in demand for loans from the household sector, with housing and consumer loans rising sharply in Q1 2013.

The real gains in exports

Prime Minister Shinzo Abe’s fiscal stimulus, combined with the Bank of Japan’s massive bond-buying program that aims to double the monetary base in the next two years, has led to a 15 percent depreciation of the Japanese yen in May since the end of last year. The yen weakened against the US dollar, reaching 100 JPY/USD during May for the first time since 2009. This depreciation has helped improve Japan’s export competitiveness and thus its exports, which grew by 3.8 percent quarter on quarter after declining for three consecutive quarters prior to Q1 2013. Exporters will likely continue to benefit as the currency is expected to weaken further this quarter. Early indications for Q2 are promising, with exports rising by 5 percent in the first 20 days of April compared to a year earlier.

Weak currency can be an important instrument for achieving the dual objective of high growth and inflation. While depreciated currency will likely help the export-oriented sectors—the signs of which are already visible—the impact on inflation via exchange rate pass-through can be substantial.

According to the government survey in April, the consumer confidence index remained close to its highest level since 2008, as the outlook for livelihood, income growth, employment, and willingness to purchase improved among consumers.

Prices yet to respond

Concerns about deflation persist as consumer-price inflation fell sharply in Q1 2013. However, the new monetary policy framework announced by the government in January, followed by quantitative easing by the central bank of Japan, has increased short-term inflation expectation in the economy. In a survey by the Bank of Japan conducted in April, the number of respondents that expect prices to rise by more than 2 percent increased by 15 percentage points, to around 60 percent, since Abe became leader in early December. Since the impact of monetary policy on prices comes with a lag, prices will likely trend up by the end of 2013.

High volatility in financial markets

The equity market went up by more than 40 percent since the end of 2012, before plunging a few points in the last week of May. The continuous rise in the equity market was fuelled by the continued currency depreciation and recent aggressive monetary easing by the Bank of Japan. Interest spreads and 10-year government yields are the lowest since 2008, signifying investors’ rising confidence in Japanese leaders and the economy. Firms’ funding costs have been hovering at low levels as financial institutions’ lending attitudes maintain an improving trend.

The recent fall in the Nikkei index and the rise in bond yields and bond-market volatility have unnerved investors and banks, which are heavily exposed to the rise in yields of Japanese government bonds. Japan’s burden of government debt, which is now at close to 250 percent of GDP, is a serious concern. Any rise in yields can quickly push the cost of servicing government debt to unsustainable levels. However, these recent events could be a short-term correction in Japan’s financial market, and is most likely an impact of the Chinese slowdown and a signal from the US Federal Reserve of a possible exit in the near future. Japan’s financial system is strong, as the Bank of Japan’s April Financial Systems Report does not indicate any financial imbalances stemming from bullish expectations.

Corporate sector still cautious

The level of business investment in January–March was the lowest since Q2 2011. Private nonresidential investment continued to be a drag on growth for the fifth continuous quarter, while businesses reduced inventories last quarter, together shaving 0.3 percent from growth. The Bank of Japan’s Tankan business-conditions survey forecasts that businesses will remain cautious, since perceived unfavorable business conditions may continue to outweigh favorable conditions.

Risks that can change the optimism

The rise in real growth in Q1 2013 is a positive sign for Japan’s economy and for its policy makers, who are putting in a lot of effort to push the economy out of the 15-year deflation and low growth. But ensuring sustained long-term growth is going to be a challenge because of substantial domestic and external risks. High public debt and the fiscal imbalance continue to worry investors and weigh on business sentiments. In addition, uncertainties regarding global growth, changes in US monetary policies, and commodity prices can throw sudden surprises in the financial market and threaten desired policy outcomes.